Benefits of Diversification at Yale Endowment

The Yale Model has survived past market crisis because of diversification. More than likely it will survive this pandemic.

Just as roaring bull markets encourage diversification skeptics, so do acute financial panics. Based on the substantial decline in Yale’s Endowment during the 2008 financial crisis, some observers questioned the University’s diversified, equity-oriented approach. Particular criticism focused on the Yale model’s failure to protect the Endowment in the early months of the financial crisis. The criticism, while superficially true, falls short in two ways: 1) in a financial crisis (the market crash in 1987, the Long-Term Capital Management failure in 1998, the Internet bubble collapse in 2000 and the Great Financial Crisis in 2008) all risky assets fall in price as market participants seek the safety of government bonds, leaving government bonds as the only diversifying asset that works; and 2) when evaluated over a reasonably long time frame, the opportunity costs of holding government bonds impose a significant drag on portfolio returns.

The fact that diversification among a variety of equity-oriented alternative investments sometimes fails to protect portfolios in the short run does not negate the value of diversification in the long run. Consider an investor in Japanese equities in 1989. An undiversified portfolio invested in the Nikkei at the end of 1989 suffered a decline of 24% in local currency terms for the thirty years through June 30, 2019. Diversification matters.

The University’s discipline of sticking with a diversified portfolio has contributed to the Endowment’s market-leading long-term record. For the thirty years ending June 30, 2019, Yale’s portfolio generated an annualized return of 12.6% with a standard deviation of 6.8%. Over the same period, the undiversified institutional standard of 60% stocks and 40% bonds produced an annualized return of 8.7% with a standard deviation of 9.0%. Yale’s diversified portfolio produced significantly higher returns with lower risk.

The Yale Endowment 2019, Yale Investments Office

Last year the endowment reported that its venture capital portfolio earned 165.9% per annum over the previous twenty years.

Yale’s venture capital program, one of the first of its kind, is regarded as among the best in the institutional investment community; the University is frequently cited as a role model by other investors. Yale’s venture capital managers field strong, cohesive and hungry teams with proven ability to identify opportunities and support talented entrepreneurs. The University’s venture capital portfolio contains an unparalleled set of manager relationships, significant market knowledge and an extensive network. Over the past twenty years, the venture capital program has earned an outstanding 241.3% per annum.*

Footnote: Yale’s 241.3% venture capital return over the past twenty years is heavily influenced by large distributions during the internet boom. Since such a calculation assumes reinvestment of proceeds from the portfolio during the period at the same rate of return for the rest of the period, it is inappropriate to compound the 241.3% return over the twenty-year time horizon. For reference, the twenty-year time-weighted return of Yale’s venture capital portfolio is 20.2%.

Calculating performance returns requires a nuanced understanding of the underlying cash flows.

The Alma Mater mural inside the Sterling Memorial Library at Yale.
Twitter @Yale

Post by Marcelino Pantoja